The IRS has just announced that it will treat Bitcoin and other virtual currencies as property, rather than currency. [Although there are a number of different virtual currencies, to keep things simple I will just refer to them all as Bitcoin. Also, like sheep and fish, the plural of Bitcoin is simply Bitcoin.] This will impose some new tax and reporting burdens on people who choose to use these new payment systems. Although holders of Bitcoin treat it as a currency, using it to pay for products and services, the IRS made clear that Bitcoin does not have legal tender status in any jurisdiction.
The IRS decision to treat Bitcoin as property rather than currency could result in discouraging its use as a payment method. Now users of Bitcoin will have to track the change in value from the date Bitcoin was acquired to the date it was spent, and treat any change in value as capital gains or loss. For example, let’s assume that on January 1, 2014 you acquired 100 Bitcoin at an aggregate value at that date of $100,000. On February 10, 2015, you spend those 100 Bitcoin on a tricked-out Land Rover. On that date, 100 Bitcoin have a value of $140,000. You would incur a long-term gain of $40,000, and would pay tax on the gain at a rate of 20% if you are in the highest bracket. If you had used the 100 Bitcoin on February 10, 2014, any gain would be subject to the short-term capital gains tax rate of 39.6%, a substantial difference. This may create an incentive to hold Bitcoin like shares of stock, rather than use them as currency, at least for large transactions. However, the imposition of capital gains tax on any increase in Bitcoin value, even at 15%, discourages the casual use of Bitcoin as a payment method.
Online exchanges that buy and sell Bitcoin will have to provide their customers with annual transaction reports, just as stock brokerage firms do for their customers. Employers who pay employees in Bitcoin (apparently there are a few) will have to report those wages, and the pay will be subject to normal withholding and payroll taxes.
Bitcoin miners will have to report their earnings as taxable income with a value equal to the worth of the Bitcoin on the day it was mined. If someone mines Bitcoin as a business, the net earnings will be treated as self-employment income, subject to self-employment tax.
For investors in Bitcoin, the new ruling is a positive development. They will get the benefit of the capital gains tax treatment if they meet the holding period requirements. The alternative would have been to treat change in Bitcoin value as foreign currency gain or loss, which is taxed at higher individual tax rates, whether earned by an individual or a corporation.
For more detailed information, the IRS guidance can be found here (pdf).
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